Rebooting America’s Job Engine

SARAH GREEN: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Sarah Green.

Innovation, entrepreneurship, and job creation. Today, we’ll be talking about how America’s economic engine has stalled and how we can get it back on track. Our guest this week is Henry Nothhaft, a highly successful serial entrepreneur and the author of Great Again: Revitalizing America’s Entrepreneurial Leadership.

Hank, thanks so much for talking to us today.

HENRY NOTHHAFT: Oh, good morning, Sarah, and thank you for having me. It’s my pleasure.

SARAH GREEN: So I just want to get right to the heart of the issue here. In the book, you write that the connection between innovation and job creation has broken down. What is that connection and why has it deserted us?

HENRY NOTHHAFT: Well, historically, there has been a connection in our history between technological innovation and job creation. And as we can see here during the recession that we’ve just gone through and are still going through, that unemployment spiked extremely high, and now we’re having a very, very slow recovery.

And so if you look at the seven recessionary periods that we had post-World-War-I prior to 1990, the recovery period in every case was an average of four months. Starting with the 1990 and then the 2001 recession, the recovery periods started to become longer. In 1990, it took 17 months to get back to positive employment. In 2001, it took 30 months to get back to positive employment. This time, as you can see, it’s taking and will take years.

And so I asked myself what was causing this deterioration of job recovery, and why were we suffering these extended recovery periods? And it turns out that in my research, it verified my impressions that small companies have been the major job creator in the US for a number of decades. And then, as I delved into it further, it turned out that it’s actually startups that create all new jobs in the United States.

There was some new leading-edge research that was funded by the Kauffman Foundation but actually done by the Census Bureau, where they actually could start looking at the maturity of small businesses from the time they started till the time they failed. And it turned out that since 1977, all new job creation in the US has been due to startups.

And so when I say the system has broken down, there’s been such a critical tipping point of uncoordinated, though well-intended, regulation that we finally have gotten to the point where we’re choking off the ability of small companies to start and succeed and create jobs in the US.

SARAH GREEN: So can any new small business do this, or are you talking only about a particular type of startup?

HENRY NOTHHAFT: Oh, thank you for asking that question. There’s about 600,000 to 700,000 startups a year. Many of them are just a coffee shop, a dry cleaner, a delivery service, and what have you. And they do create jobs, and they are vital to the economy, though most of them live short and brutish lives and actually fail after about a year. But 20% or more do survive.

But the key to really creating lots of jobs really starts narrowing down to generally venture-backed, generally high-tech startups. Because as I call them and others have called them, gazelles, they have the opportunity and the ability to scale and really create significant numbers of new jobs.

SARAH GREEN: Let’s talk a little bit about some of the obstacles for these startups. What are some of the regulations that seem to get in the way?

HENRY NOTHHAFT: Yes. The biggest single regulatory issue that startups have to deal with is Sarbox, the Sarbanes-Oxley law that was passed just after all the tumult that was going on in the country after the 9/11 attack, which was almost 10 years ago, and the failure and the chicanery that was uncovered at companies like Enron and MCI.

So it was a very dark time in the country. Congress has, at times, overreacted. I would say this was one of those times. And so they passed a sweeping piece of legislation to try to prevent future Enrons and future MCIs from happening. And in so doing, they did what I like to call passed a piece of legislation where one size fits all. They really didn’t take into account that the chances of a 15- or 20-person venture-backed company out of Silicon Valley which doesn’t use leverage and has no threat to the financial system in the country should be experiencing the same degree of regulations and expense that, say, a large company like a financial institution like Lehman Brothers or Bear Stearns.

So I would like to point out that even the primary target, very large companies that were all Sarbox-compliant, and even though they were Sarbox-compliant, really were the key to the financial meltdown that we just went through in 2008.

But back to startup land, it’s disproportionately affected startups. It’s created a huge financial burden to comply with the Sarbox requirements. And as a result, in 2008, we only had six venture-backed IPOs in the United States. The next year, we had 12. And we had a few more in 2010, but compared to the decade prior to that where we were having 170 to 180 legitimate venture-backed IPOs per year, it’s done more than any single element to choke off IPOs.

And so if you look at the whole US economy and you go back to all the companies that were backed by venture capitalists from 1970 to today, they represent about 11% of all the private employment and 21% of the GDP. So that’s why we should care. And the biggest regulatory hurdle was person-made, induced by the US Congress, and we really should make changes to Sarbox to carve out small businesses, say, with a market value of probably 500 million would be the range that should be considered.

SARAH GREEN: So clearly Sarbanes-Oxley is a big obstacle in your view. My question, though, is with these regulatory issues and other big problems, is there anything that individual executives can do about this?

HENRY NOTHHAFT: Well, I think it’s imperative of people in business to become involved. In my case, I chose the patent system, the Patent Office and patent reform because it affects my company so directly. We have 2,300 patents, and we spend 70 to 80 million dollars a year in R&D. And we generally produce somewhere north of 100 new patents per year.

And so as a CEO maybe 10 years ago, getting involved in public policy matters might not have seemed a critical part of the role. Today, I would say, whether you’re running a private venture-backed firm, perhaps in the clean-tech environment, or perhaps you’re trying to get funded for a semiconductor company in the United States, or whether you’re running a public company, I would advocate, and I do advocate, that everybody pick an issue and get involved and try to affect the outcome. And I would encourage all the citizenry to get off the bench and get in the game.

SARAH GREEN: So going a little further in that same vein, I found it interesting that you wrote in your book that you and your co-author tried to make this as non-partisan a book as possible, and actually that one of you’s on the left and the other is a little more to the right.

How did you work on a book like this with someone you didn’t always see eye-to-eye with?

HENRY NOTHHAFT: Well, it was a very interesting process, and I think it changed both of our views somewhat. And we decided to go with a fact-based approach and try to take the emotional-based wording and trigger words out of our vocabulary and try to investigate the problems that we picked out on a fact-based approach.

And we did try to pick issues that we felt were issues that could be affected by some practical, commonsense policies. So we chose not to address certain issues that are huge problems for the US, but we felt they were beyond the scope of what we knew about and what we could recommend that are problems of huge scale.

I would point that we did not address the education system in the United States, which I think is one of the key problems that we have. But we chose to stick with issues that we thought we could do fact-based research, recommend commonsense approaches to them, and that we could actually, if we could convince people to consider our views, that we might be able to make some actual positive changes in the environment.

SARAH GREEN: Well, so, in that case, let’s bring it back to something that seems to frustrate people on the left and people on the right, which is the US Patent Office. What happened to the US Patent Office that it has gotten so dysfunctional?

HENRY NOTHHAFT: So what happened, starting around 2002, the Patent Office seemed to really lose its edge. And the number of patents that were being filed were not being processed officially. And so more patents were coming in than they were able to process and either deny a patent or issue a patent on. So before 2002, you could apply for a patent, generally expect an answer in a year, year and a half, which is perfectly reasonable. After 2002, that time started increasing.

And also during 2002 through the present, Congress under both parties– so we’ll be totally bipartisan there– have been diverting funds from the Patent Office. So let me explain. The Patent Office is the only totally self-funding agency in the US government. It collects fees from people that file for patents, and then it does future work for those fees.

So it has been taking in more money every year than Congress has been allowing it to spend. So let’s say this year, the Patent Office will take in $2.2 billion in fees. The Congress, which gives them spending authority, is only allowing them to spend, say, $2.2 billion, therefore diverting $200 million for other purposes.

And this has been going on for 10 years, and a billion dollars has been diverted. They’ve been treating the Patent Office like a petty cash drawer for the rest of the government. And so as a result, during this period of time, instead of getting a patent in a year, it now takes three to four years to actually get a patent issued.

So let’s say I think I have an invention or the cure to a disease, a nasty disease, let’s say, like lupus. We cover this in the book. Innate Immunity, some world-class biotechnology executives, felt they had a potential cure for lupus. Their IP attorney, one of the best intellectual property attorneys here in the Valley, believed that their invention was, in fact, patentable. They filed for a patent, lined up a great management team, lined up Tier 1 venture capitalists to fund the business plan, and nothing was forthcoming from the Patent Office.

So even though they were very aggressive, had top-flight legal counsel, and aggressively pursued the Patent Office, years went by, literally, and they could not get a patent issued. And so they couldn’t raise the money. And it took seven years for them to get the patents issued. And now they do have some funding, they now are proceeding, but there’s been a seven-year delay in potentially curing or dampening the symptoms of a disease which actually can be fatal. So that is a real burden.

And by diverting this money from the Patent Office, it’s like an innovation tax on the country. And this is really in contrast to our economic competitors. If you file for a patent in Korea, you actually can get a patent in less than a year in Korea. So we do not have a world-class-standard patent office at this point in time. And there’s really little excuse for it, frankly.

SARAH GREEN: Well, so that’s clearly an example that’s very frustrating. At the same time, though, I think we’d be remiss if we didn’t mention that, in this lost decade that you talk about, we have seen examples of some companies that have been great success stories, some of the buzzy companies you hear about like Google and Facebook and even Twitter, now.

How come you don’t seem to give more credit to those startups? Don’t they offer economic growth?

HENRY NOTHHAFT: Well, I admire their accomplishments, so I want to be absolutely clear on that from a business point of view. But from a job-creation point of view, it really reflects on the fact that, as we’ve offshored and outsourced our manufacturing, that the venture capital community seems unwilling to finance capital-intensive business plans here in the US. So if you were going to start a semiconductor fab or some kind of a manufacturing company, you could probably raise the money here, but you’d be manufacturing and creating most of the wealth and jobs would be in China or perhaps India or somewhere like that.

So the social media plays are great success stories, but they’re not particularly capital-intensive. And they do not create large number of jobs. And so let’s take Facebook an example. So I said the IPO market has been shut down. Sarbox is not the only reason, but a lot of other reasons. And so Facebook has not gone public. They’ve raised substantial amounts of money, hundreds of millions of dollars, in funds. And if we’re to believe the leaks that come out in the press, they’re up to a $50 billion valuation on the company.

But with 500 million users or more and growing rapidly, they only have, I think, at the time I wrote the book, 1,400 employees. I believe today they have 2,200 employees. So despite the success, which is phenomenal, admirable, two things have not occurred. One, it hasn’t created a lot of jobs. And two, because there hasn’t been an IPO, the normal process where you have an IPO and the wealth is distributed through a broader base of people than a couple of the founders and rich clients of Goldman Sachs, we’re missing that virtuous cycle that used to be the way business was done in Silicon Valley.

You mentioned Google. It’s really a fairly modest number of employees when you think about the market capitalization of these companies, and then you think about, say, Walt Disney, Sony Corporation, Boeing, or what have you, which have lesser market capitalizations, but they have anywhere from 175,000 to 250,000 employees.

It’s not that I’m not a fan of social media companies. My son actually co-founded one and is doing a startup as a second-generation entrepreneur. My point is that the venture capitalists and the way the regulatory environment is in the US right now is capital-intensive startups that rely on hard sciences aren’t being funded in the US, and all of that activity is taking place in China. Whether it’s being funded by US venture capitalists or being funded by offshore venture capitalists, the manufacturing plays, the hard sciences, the building of a huge middle class is taking place in China, while we’re hollowing the middle class out here in the US.

SARAH GREEN: Well, Hank, it’s clearly a very complex issue. Thanks so much for taking the time to help us think through it all.

HENRY NOTHHAFT: Sarah, it’s been my pleasure to talk to you this morning. Thank you for having me.

SARAH GREEN: That was Hank Nothhaft, and the book is Great Again. For more, go to hbr.org.